How Tax Reform Could Affect Muni ETFsPresident Donald Trump is looking to make sweeping changes to the U.S. tax system and that effort could have consequences, both good and bad, for a variety of asset classes.

Some bond market analysts and participants are concerned about the impact a Trump presidency will have on municipal bonds.

Prior to the Fed raising interest rates for the only time last year in December, income investors widely embraced muni ETFs. However, the Fed is targeting three rate hikes for 2017, a scenario that could pressure fixed income assets.

The iShares S&P National AMT-Free Muni Bond ETF (NYSEArca: MUB), the largest municipal bond ETF, is a favorite destination for investors looking for income with the specter of high credit risk.

Since muni bond interest is exempt from federal taxes, muni ETFs are a good way for investors seeking tax-exempt income, especially those in higher tax brackets. Due to its tax-exempt status, the asset category is also best utilized in taxable accounts. The tax-exempt status also creates high demand for municipal bonds. Consequently, the perceived bond yields are typically lower than their taxable counterparts.

“The hard truth: Lower individual tax rates reduce the value of a municipal bond’s tax exemption. For example, a drop in the top tax rate from 43.4% to 33% means $4,340 in annual savings would be reduced to $3,300. And to the extent that lower tax-exempt benefit mutes the demand for municipal bonds, market valuations could suffer,” said BlackRock in a recent note.

Municipal bonds continue to experienced robust demand from U.S. investors as reliable source of yield, especially among taxable accounts due to the debt securities’ favorable tax-exempt status. Recently, Japanese investors have gobbled up U.S. munis as a way of generating income as Japan maintains negative interest rates.

“The tax exemption of municipal bond interest is a key draw for issuers. And while it may be deemed alterable, we don’t see it as dispensable. States and municipalities rely on municipal debt as a low-cost, efficient way to finance capital improvements and fund infrastructure. The federal government hurts itself if it impedes state and local ability to create jobs, sustain their economies and improve the quality of life for Americans. As such, we see the elimination of muni tax exemption as highly unlikely,” adds BlackRock.

The municipal market also comes with high quality and low volatility traits. The asset category has experienced lower volatility than other bond categories and tends to be less affected by Federal Reserve rate uncertainty than high-quality taxable investments, like Treasuries.

For more information on the munis market, visit our municipal bonds category.

Tom Lydon’s clients own shares of MUB.

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